Dividend is that part of profit after tax that is distributed to the shareholders of the company. Stock dividend creates a favorable psychological impact on the shareholders and is greeted by them on the basis that it gives an indication of the company's growth. Taxation: According to Section 115-O of Income Tax Act, 1961, dividend is subject to dividend distribution tax (DDT) in the hands of the company.
They retain all profits and declare bonus shares to offset shareholders' dividend demands. So, a small part of the income is kept to meet the emergency and occasional financial needs. These companies increase the amount of dividends gradually as profitable investment opportunities begin to decline. i) Legal: According to Section 123 of the Companies Act 2013, dividend shall be declared or paid by a company only for each financial year:.
The dividend policy, which is therefore pursued by the company, should find a balance in the desires of the shareholders. The dividend policy should also be continued as long as possible without interfering with the needs of the company to create customer effect. The amount of dividend may increase or decrease later depending on the financial health of the company, but it will be maintained for a considerable period of time.
The dividend policy is to distribute up to 30% of the Infosys Group's consolidated profit after tax (PAT) as dividend.”.
THEORIES OF DIVIDEND
Dividend’s Irrelevance Theory
However, there is a risk that a company with a stable dividend pattern will not pay dividends in a year, as this interruption will have a severe effect on investors as the inability of a company with an unstable dividend policy to pay dividends. The dividend rate should be set at a conservative level so that it can be maintained even in such periods. When a company does not pay an additional dividend, it does not have a depressing effect on investors.
Assumptions of M.M Hypothesis
According to the MM hypothesis, the value of the firm will remain unchanged due to the dividend decision. Vf = Value of the firm at the beginning of the period n = number of shares at the beginning of the period.
Advantages of MM Hypothesis
Limitations of MM Hypothesis
Value of the firm when dividends are not paid
Value of the firm when dividends are paid
Thus, the example shows that the value of the company remains the same in both cases.
Assumptions of Walter’s Model
This assumption is necessary for the universal applicability of the theory, since the tax rates or provisions for taxation of income may be different in different countries. Ke = Cost of equity/ capitalization rate/ discount rate. r = Internal rate of return/return on investment. The above formula given by Prof. James E. Walter shows how dividends can be used to maximize shareholder wealth.
He argues that long-term stock prices only reflect the present value of expected dividends. A close study of the formula indicates that Professor Walter emphasizes two factors that affect the market price of a stock. If the internal rate of return from retained earnings is higher than the market capitalization rate, the value of common stock will be high even if dividends are low.
However, if the internal return within the business is lower than the market expects, the value of the stock would be low. Walter's model explains why the stock market prices of growth companies are high even though the dividend paid is low. It also explains why the market price of shares of certain companies that pay higher dividends and maintain very low earnings is also high.
As explained above, the market price depends on two factors; first, the amount of the dividend and second, the profit opportunities available to the company in investing retained earnings. Clearly, when a company retains a portion of its earnings, it must consider the cost of such retention. Retention of profits depends on whether it is cheaper and more profitable for the shareholders of the company to keep the corporate profits in the business or to receive the same in the form of cash dividend.
This includes a comparison between the cost of retained earnings and the cost of distributing it. The cost of retained earnings therefore includes opportunity costs, i.e. the benefits that shareholders forgo if they leave assets in the company.
IRR, K e and optimum payout
Correlation between Size of Dividend and
Optimum dividend payout ratio
Advantages of Walter’s Model
Limitations of Walter’s Model
GORDON’S MODEL
Assumptions of Gordon’s Model
According to Gordon's model, the dividend is important and the company's dividend policy affects its value. Ke > g, this assumption is necessary and is based on the principles of a series of sum of geometric progression for 'n' number of years. According to Gordon's model, when the IRR is greater than the cost of capital, the share price increases and the dividend payout decreases.
On the other hand, when IRR is lower than the cost of capital, the price per share falls and dividend payouts increase.
Optimum dividend payout ratio
Myron Gordon revised his dividend model and considered the risk and uncertainty in his model. Gordon's bird-in-the-hand theory has two arguments: i) Investors are risk averse and. ii) Investors place a premium on certain returns and discount uncertain returns. They would prefer to pay a higher price for shares that pay ongoing dividends.
The formula given by Gordon shows that when the rate of return (r) is greater than the discount rate (Ke), the price per share when the dividend ratio falls and if the rate of return (r) is less than the discount rate (Ke) it is the other way around. The price per share remains unchanged where return and discount rate are equal.
DIVIDEND DISCOUNT MODEL (DDM)
Gordon argues that what is currently available is preferable to what may be available in the future. P0 = Current market price of the share ILLUSTRATION 5. is a non-growth company, pays a dividend of `5 per share. However, the most common form is one that assumes 3 different growth rates: an initial high growth rate, a transition to slower growth, and finally, a steady, steady growth rate.
Basically, the constant-growth-rate model is extended, with each phase of growth calculated using the constant-growth method, but with 3 different growth rates of the 3 phases. The current values of each stage are added together to derive the intrinsic value of the stock. Sometimes even the capitalization rate, or the required rate of return, can be changed if changes in the rate are projected.
DETERMINE the estimated market price of the equity share if the estimated growth rate of dividends (i) rises to 8%, and (ii) falls to 3%. Also FIND the current market price of the stock, given that the required rate of return of the stock investors is 15%. Thus, the market price of the stock is expected to fluctuate in response to changes in the expected growth rate of dividends.
Advantages of Gordon’s Model
Limitations of Gordon’s Model
Graham & Dodd Model
Mature companies with stable earnings can have high payouts, and growth companies usually have low payouts. A manager can easily decide to pay a dividend of ` 2 per share if last year also it was ` 2 but to pay ` 3 dividend if last year dividend was. Under Linter's model, the current year's dividend is dependent on the current year's earnings and last year's dividend.
Criticism of Linter’s Model
STOCK SPLITS
- Meaning of Stock Split
- Advantages of Stock Splits
- Limitations of Stock Splits
The number of shares can increase the number of shareholders; hence the investment potential may increase.
Miscellaneous Illustration ILLUSTRATION 11
Rate of return on investment 15%. i) What will be the market value per share according to Walter's model. ii). What is the optimal dividend payout ratio according to Walter's model and the market value of Company's stock at that payout ratio. i) Walter's model is given by. ii) According to Walter's model, when the return on investment is more than the cost of equity capital, the price per share increases as the dividend payout ratio decreases.
Factors Growth Firm
Normal Firm
Declining Firm
SUMMARY
TEST YOUR KNOWLEDGE
MCQs based Questions
It is the indicator to retain more income (c) It has no influence on the dividend decision (d) I can't say.
Theoretical based Questions
Practical Problem
Using the following figures, CALCULATE the market price of stock a. ii) Dividend growth model (Gordon formula).
ANSWERS/SOLUTIONS
CALCULATE the market price of a share of a using the following figures. ii) Dividend growth model (Gordon's formula) Earnings per share (EPS) ` 10 Dividend per share (DPS) ` 6. The P/E ratio is given at 12.5 and the cost of capital, Ke, can be at the inverse of P/ V ratio. the value of the share according to Walter's model can be found as follows:. since the rate of return of the firm, r, is 10% and it is more than the Ke of 8%, therefore, by distributing 75% of earnings, the firm is not following an optimal dividend policy. The optimal dividend policy for the firm will be to pay zero dividend and in such a situation the market price will be.
So, in theory, the market price of a stock can increase by accepting a zero payout. ii) The P/E ratio at which the dividend policy will not affect the stock value is one at which Ke would be equal to the rate of return, r, of the firm. Therefore, at a P/E ratio of 10, the dividend policy would have no effect on the stock's value. Market price per share according to (i) Walter model:. ii) Gordon Model (Dividend Growth Model): When growth is included in earnings and dividends, the present value of the market price per share (Po) is determined as follows.
